Friday, September 30, 2011

Linkage roundup

Some links I found interesting today:

Gillem Tulloch video on Chinese money supply, lending, and housing problems.  As I mentioned previously negative real rates in a growing economy create massive distortions:

ECRI calls for another recession in the US:

Wednesday, September 28, 2011

Can the long bond go further?

The recent drop in long term yields is impressive and historic.  While the 30 year treasury yield has backed up a bit it is still very low, currently in the range seen during the depth of the financial crisis of 2008.

I'm not trying to convince you of whether it can go lower in this post even though I currently own long term treasuries. I'm considering selling of some of my position and this blog post is part of me thinking aloud about the situation.

What is interesting about this current phase of declining interest rates is how the 10 year has broken new lows while the 30 year, while low, is not in record territory yet.  (Note the 30 year was not issued for part of the 2000's. You'll see gaps in the data during that period)

30 and 10 year yields

Looking at the difference between 30 and 10 year yields provides a very different picture.

30 year less 10 year yield

While the spread has declined recently we are still in rare territory when the difference between the 30 and 10 is greater than 1%.  What this all means I honestly don't know yet but I thought I'd share with you yet another example of  how our unique our current situation is.

The author owns long term treasuries and is considering paring back his position.

Tuesday, September 27, 2011

Kicking Copper while its down

A little more than six months ago I laid out a bearish case for the red metal, also known as Dr. Copper by those in the markets for its ability to predict future economic change.  With the recent thrashing copper and many other risk assets have taken I thought revisiting the topic would be a good idea.

While China is a large factor in all base metals prices let's start with the Old World and the seemingly mundane issue of actually counting how much copper inventory is on hand.  While this would appear to be as simple as looking up the LME (London Metal Exchange) and COMEX (US futures) inventory numbers it really isn't.  The BBC ran a three part series on rising commodity prices in late May and spent nearly a third of the program on copper.

BBC Radio - Bubble Trouble - Part 1 - May 28,2011
BBC Radio - Bubble Trouble - Part 2 and 3 blog highlighting the inventory issue
In part 2 around the seven minute mark the presenter takes a tour of a well known base metals warehouse in which the warehouse representative reveals only about 40% of the copper in the warehouse is registered as LME inventory.  When I heard the words I had to replay it several times to ensure I understood that correctly; my brain almost rebelled at the concept of anyone just coming out and publicly stating such a figure.  Now I'm not suggesting the LME reported amount is under counting European stocks by 40%, just that this one warehouse has a lot more copper inside its walls that is reported to LME.  Please listen to at least part 2 of the radio series to get the full details.  If it can happen in one warehouse in Rotterdam what is preventing it from happening elsewhere in the world?

So why is the copper 'hiding'? Some of it is because costs are cheaper to store it in a non registered warehouse versus an official LME warehouse. Another factor may be what is suspected to be going on in China. FT Alphaville has discussed import/export trading firms there are using copper as a credit funding vehicle because other more official forms of credit are drying up.

From blog
Here’s the gist of it.In the first instance, our source says, the strategy is not exclusive to copper markets but goes on across most commodity markets.
The banks call it “inventory financing”. And of course, we should stress, it is completely legal. The practice mainly involves pledging an asset in return for an exchange warrant or cash.
According to our source, traders can deposit copper in an exchange warehouse in order to receive a warrant which can then be used to gain financing, usually via a broker, and less a 15 or 20 per cent haircut needed to cover futures margin deposits (sometimes called margin or warrant financing).
Read the whole article to get the full weight of what they are doing. This copper-as-financing would help explain why copper continues to be imported even though for most of 2011 it has been cheaper on the domestic Shanghai exchange. For the credit focused copper trader the money created by the transaction has greater value than the actual copper, it is just a funding mechanism.

While the discount has been steadily falling one must understand China is a net importer of Copper; so why has it been cheaper to buy copper inside China?

Izabella Kaminska followed up a few weeks later with more details on the same copper-as-collateral trade
More worryingly however is that the primary use of copper in bonded warehouse appears to be as a financing mechanism to provide cheap working capital for various types of business often unrelated to the metallic industry.
Another copper financing entry at

Simon Hunt, of Simon Hunt strategic services actually goes to China and tries to see what is happening on the ground and his opinion is not bullish.  An audio interview from March 29 is very interesting.

Having just come back from China my impression is that more and more people are beginning to understand that a lot of copper that has been imported has not gone into furnaces, that it is held by both foreign and Chinese financial institutions and others and I do think that even at the top level in government there is now starting to be a concern of the impact of this speculation on China's economy.  Because it is not just copper - it goes much deeper than that.  With money which has been so freely available in recent years, and with negative deposit rates, any company or individual is very reluctant to hold funds on deposit.  So they are looking for other means of investment and it goes into commodity markets generally - the stock market, it goes into manufacturing investment and so on so forth.  Whether government does anything to stop this game going on I've no idea, but there is at least a realisation at a pretty senior level that these developments are ongoing. 
Mr. Hunt also brings up the insidious problem of negative real interest rates in a growing economy.  Empty cities such as Ordos are an example of what happens when people respond to the obvious distortion of losing money when you put it in a bank account.

Even the Chileans are publicly talking about the excess inventory in China
The world No.1 copper producer, Chile's state-ownedCodelco, sounded a warning shot at the CESCO copper industrygathering in Santiago on Monday, saying copper stocks in China were abnormally high and needed to be watched carefully.

Figures are tossed about regarding how much inventory has been tied up in these financing deals but one never really knows how much until the real washout hits and people are forced to dump their positions.
That being said, some analysts are putting out huge numbers as to the extent of hidden inventory, again from blog
The ICSG data shows an increase in Chinese demand of 99% for the four years between 2005 and 2009 when Chinese GDP probably rose by about a third. Obviously, there cannot possibly have been such a massive rise in copper’s intensity of use in China. You can look through all the intensity of use curves for every commodity for every economy in history and you will never find a doubling in consumption against a one third increase in GDP over so short a period of time.  
The numbers are large, around 4 million tonnes since the end of 2006. This dates from when global fabricators and others started to understand that a new paradigm in the copper market had begun. It was the involvement of the financial community by buying copper directly from producers and others and warehousing the metal outside the reporting system.
Standard Chartered puts the amount of hidden inventory lower, but still extensive, April 28
 High inventories in bonded warehouses point to the possibility of destocking, which could hit copper prices on the London Metal Exchange (LME). As of this week, we estimate that total copper stocks in bonded warehouses in Shanghai (usually 80% of the national total) have hit 650 thousand tonnes (kt) – equivalent to roughly four weeks of China's domestic use, a record-high level (Chart 2). This is significantly higher than 550kt in late February and the 200kt average over the past three years.

ETFs have been a useful tool to allow banks to move risk off balance sheet. When a bank takes on risk through lending to or financing a big commodity player, say for an acquisition, there is a need to hedge potentially huge commodity exposure — so as sell to lock in the commodity price, and you couldn’t sell that volume easily into the terminal market; although you could transfer a large amount of exposure to investors through an ETF more easily. The only way this used to be done is by the bank taking proprietary risk, but they now have other risk issues and aren’t prepared to carry that sort of exposure.
Using ETFs becomes a mutuality of interest, with everyone moving to launch products to investors – retail and institutional – so that they can carry the risk instead. It’s all about de-risking your book. And you saw it in the dot com bust when investment banks pushed dotcoms, but offloaded the risk to investors. When the NASDAQ crashed the investors carried the bulk of the exposure.It all has similarities to the Abacus CDO. If you want to short the market you have to create the demand, like Paulson did. If you are an institutional advisor you can do that by hyping the commodity.

The actual import numbers going into China for both refined and scrap do not mesh well with the meme of voracious demand. On a year over year basis both are falling.

Furthermore the reported inventory numbers have been wandering around the 600k number for a while. Ironically the last time year over year inventory numbers dipped into negative territory for a while was 2008.

I'm not the only one who is not a copper bull.  The Reformed Broker sums it nicely while debating a copper bull:

I will admit some of my thesis is based upon information that is not reported as cut and dried numbers that can easily be looked up on a computer screen but what I do find does not add up to the template of China hoovering up all known copper deposits in the universe:

  • Copper is cheaper in Shanghai than in London
  • Copper imports of all kinds are dropping
  • Public reports of a LOT of hidden copper stocks, in the Old Word as well as China and confirmed by Chileans
I could go on but you need to put in some work as well. Read over the links below. I saved a few bombshells  for your discovery...

Additional reading: -- Page 2 -- If the warehouses are about to be empty of any metal, why buy them? - another estimate in an SEC filing guessing there's 2.8 million metric tons in hidden copper stocks. - More on the 2.8 million ton question.|a

The Author is long precious metals and short base metals

Ordos -- Time to double down

Nearly two years ago I highlighted the city of Ordos, China and how it appeared local municipalities and investors were building an empty city with no hope of a positive return on investment.

Fast forward to present day and the same reporter made a return visit to see what has changed. While there have been a few people moving in, residential construction continues at the usual Chinese breakneck pace.  The new video show the same empty boulevards but with more skyscrapers being built in the background.

(direct link to Youtube video)

Melissa Chan provides more details in here blog entry

She interviewed the same person, Mr. Chovanec, as last time and he provides the reasons why supposedly rational people would invest in an empty city and expect a positive return.  Mr. Chovanec provides more examples of bubble behavior in China in a recent blog entry titled This is What a Bubble Looks Like

China's response to the Great Financial Crisis of 2008 was to tell the banks to lend, and they did. The resulting excessive credit growth just exacerbated the already imbalanced situation brewing in their country.  When the next monetary event comes with Greece's default I will not be around (metaphorically) to see if they will be able to 'fix' the problem again.

Google maps link to Ordos

Wednesday, September 21, 2011

Money Money + Money -- Money supply update

The broadest money supply figures available (M2 + institutional money market funds) continues to trend higher.  

A note to all of you who are fearful of hyperinflation, this figure would be skyrocketing upwards instead of being in the ~+6% year over year range if we were entering a phase of very high inflation.  Yes, the narrower measures of money supply are growing but they aren't being transmitted to the rest of the economy (see Japan, deleveraging) as there is still a reluctance to borrow by the US consumer.  See my recent previous posts on mortgage rates and  total mortgage loans outstanding for examples of how the Fed's pumping money into the financial system is not being transmitted into higher lending (and thus higher prices)

Tuesday, September 20, 2011

Verleger on high oil prices and demand destruction

I don't quite agree with the prediction towards a hydrogen economy but it is interesting to hear about the demand destruction of gasoline usage.  Mind you this conversation is about US demand. Add in emerging demand and you may see a different picture in total

Video of Verleger on gasoline consumption, heavy versus sweet crude, diesel versus gas costs --
(I would embed the video but it autoplays)
September 7 on Bloomberg

Monday, September 19, 2011

End Date Bond ETF's followup -- More options on the menu

More than a year ago I highlighted a new twist on bond etfs called the end date bond etf.  Since then Ishare's end date muni etfs have grown to manage over 185 million in total through the 2012-2017 maturity spectrum.  Not bad.

Guggenheim also rolled out both a corporate bond and high yield end date etf series, providing a wider menu of risk. Guggenheim's corp etf's run from 2011 to 2017 while the high yield field provides a 2012 to 2015 maturity spectrum.   While the high yield etf's have gathered 144 million, the corporate funds have pulled in over 430 million with one fund, the 2013 Corporates (symbol BCSD) about to break 100 million.

Hopefully someone will introduce an end date bond etf series on US Treasuries and US Tips (Inflation protected) to round out the risk profiles available. (hint hint, nudge nudge)

A few caveats are needed regarding buying and selling these etfs
  • They are still illiquid and the price can vary dramatically from the NAV of the underlying assets.  Check the fund description page and make sure you are not overpaying.
  • Diversification does not eliminate risk.  The 2017 Guggenheim Corp fund contains a large slug of financial bonds. If we have another credit event like 2008 due to a European sovereign default you could see losses on these corporate bonds (and possibly junk bonds and muni bonds)  The price the market will give you will also fluctuate.
  • Check when the bond etf actually 'matures'. Each fund complex has their own procedures and nuances as to when the funds will be distributed to shareholders.
While there are disadvantages to these (currently) illiquid etfs I find their introduction into the investing universe promising. Building a bond ladder will be much easier and cheaper with greater liquidity for smaller dollar amounts versus finding, researching and purchasing individual bonds.

End date etfs will also allow one to take advantage of rolldown in the bond market. With short rates at zero, as the maturity date approaches for a bond the yield will drop (setting credit risk aside) and thus the price rises and yield drops. Econompic explains the dynamics in greater detail.

Ishares highlights a few of these advantages in a video:

Additional reading:
Seeking Alpha guide to end date etfs
Ishares muni bond end date etf
Guggenheim menu of corp and junk end date etfs - (scroll down to bottom)

Disclsosure: The author does not own any end date etf's but is examining the muni bond etfs for purchase shortly.

Wednesday, September 7, 2011

The Swiss choose inflation, but the Chinese do not?

The Swiss central bank recently announced it would print any amount of francs required to maintain a peg of 1.20 Swiss francs to one euro.  The response was... massive

Euro / Swiss Franc

A multi percent move in currency markets is exceedingly rare. I'm not going to spill many electrons going over why the Swiss decided it was time to fix their currency as it has been a hot topic over the last 48 hours.  The WSJ and Economist have already written about it at length.  

So why bring up the topic? Because the Chinese have been doing it for years and the dots need to be connected.  I recently commented on the threat of China 'dumping' US Treasuries and how this was not the problem everyone thought it would be.

In both the Swiss and Chinese case you have a country forcibly keeping their currency away from the market clearing price for differing reasons; the Swiss exporters are getting killed while the Chinese desire to keep their workshops fully staffed by forcibly underpricing their currency.

Whatever the reason the result will be the same -- an explosion of  domestic currency and loan demand eventually forcing up demand and inflation.  The WSJ's title on the Franc peg is The Swiss Choose Inflation  Why does one not think the same will happen in China? Chovanec has highlighted the constant struggle to contain inflation in China from both a massive increase in lending and an artificially underpriced currency. 

In both cases the Swiss Franc and the Chinese Yuan will eventually find their market clearing prices regardless of central bank manipulation, either by currency price appreciation or by domestic inflation.

edit: FT links China and Switzerland as well:

Thursday, September 1, 2011

Time to refinance your home (again?)

One year ago I stated it would be a good time to refinance your home.  Once again the opportunity presents itself. The 30 year conventional home loan rate is near historic lows.

Conventional 30 year home loan rates

Theoretically the vast majority of home loans out there could be refinanced but there are a few unfortunate facts which may prevent many from refinancing: Negative equity, conservative valuations and high unemployment.  

CNN Money has a good article detailing the these 3 challenges.  

If you are wondering how monetary policy can have limits this is a good example of how and why.  In an effort to continually re-stimulated the economy and encourage society to take on more debt over time we have reached a point where historic low interest rates will just not do much for the US consumer. They are already too tapped out and low interest rates will not encourage them to borrow more let alone take advantage of the lower interest rates and buy a home; they just can't.  People 'trapped' in their homes due to negative equity also hinders future home sales as it inhibits consumers from being able to move or trade up.

Consumer home debt / GDP

The ratio of consumer mortgage debt to gdp (both nominal) was at data series highs at the beginning of the great financial crisis. Yes I know I'm comparing home debt to national GDP and not home prices but it's yet another reminder of how much debt our society has taken on.

If you are in the position to refinance and have questions give me a ring and we can talk about some of the options / pitfalls when looking for a new mortgage.

Thanks: David Merkel